AGEC Spring 2010 DuPont model of Profit Analysis

DuPont Formula ROA can be broken down into profit margin and asset turnover. Gain an insight into planning for profit improvement. Need to improve the profit margin. Need to improve asset turnover. Need to improve both!!

Improving Profit Margin Reducing expenses:  Using less costly materials.  Automation to improve productivity.  Review fixed costs (advertising, R&D, management development programs, etc.). Raising prices:  Requires pricing power.  Also requires brand loyalty.  Easier for firms with unique high quality goods.

Improve Asset Turnover Increase sales while holding investment in assets relatively constant:  Dispose of obsolete and redundant assets.  Speed up collections of receivables.  Evaluate credit terms and policies.  Identify unused fixed assets. Use idle cash to repay outstanding debts or invest in profit producing activities.

73,000 61,100 4,687 73, , , ,000 73,

DuPont Formula The use of borrowed funds can magnify returns to equity. To see this, consider the following definitions using problem 2 values: ROE = Net income / Equity = $4,687 / $186,387 =.0251

DuPont Formula The use of borrowed funds can magnify returns to equity. To see this, consider the following definitions using problem 2 values: ROE = Net income / Equity = $4,687 / $186,387 =.0251 or ROE = (Net income / Total assets) x (Total assets / equity) = ($4,687 / $233,000) x ($233,000 / $186,387) =.0251

DuPont Formula The use of borrowed funds can magnify returns to equity. To see this, consider the following definitions using problem 2 values: ROE = Net income / Equity = $4,687 / $186,387 =.0251 or ROE = (Net income / Total assets) x (Total assets / equity) = ($4,687 / $233,000) x ($233,000 / $186,387) =.0251 or ROE = ROA x Equity multiplier =.0201 x 1.25 =.0251 where: Equity multiplier = Total assets / Equity = $233,000 / $186,387 = 1.25 or Equity multiplier = 1 / (1 – Debt ratio) = 1 / (1 -.20) = 1 /.80 = 1.25

DuPont Formula Because it links several critical ratios, the DuPont formula allows you to examine how a firm generates its ROE. NI = Net income = $4,687 NPM = Net profit margin =.0642 TA = Total assets = $233,000 EM = equity multiplier = 1 / (1 – Debt ratio) = 1.25 TAT = Total asset turnover ratio = Sales / Total assets =.3133 ROE = NPM x TAT x EM =.0642 x.3133 x 1.25 =.0251

DuPont Formula Because it links several critical ratios, the DuPont formula allows you to examine how a firm generates its ROE. NI = Net income = $4,687 NPM = Net profit margin =.0642 TA = Total assets = $233,000 EM = equity multiplier = 1 / (1 – Debt ratio) = 1.25 TAT = Total asset turnover ratio = Sales / Total assets =.3133 ROE = NPM x TAT x EM =.0642 x.3133 x 1.25 =.0251 or ROE = (NI / TA) x EM = ($4,687 / $233,000) x 1.25 =.0251

Analyzing DuPont Formula strong operating management 1. A high net profit margin or NPM signals strong operating management. strong asset management 2. A high total asset turnover ratio or TAT signals strong asset management. strong capital management 3. A high equity multiplier or EM signals strong capital management in the presence of low and stable cost of debt capital.

Examining an Economic Growth Model